Reserve Bank of Australia quietly increases banks’ bailout buffer

In a globally unique policy, the Reserve Bank of Australia will supply banks with a permanent bailout facility worth up to $380 billion by 2015.

The policy has been designed by the RBA to help banks satisfy stringent new liquidity tests which simulate “acute stress scenarios” that deny banks funding for 30 days under the post-GFC rules, Basel III.

Local regulators argue that insufficient liquid assets such as government bonds meant they had no choice but to give the banks a new taxpayer-backed “line of credit” that could be tapped at a cost just above the RBA’s cash rate. Smaller building societies and credit unions are not subject to the liquidity tests and will not, therefore, have access to the bail-out fund.

Remarkably few people inside or outside financial markets are familiar with, or understand, this “committed liquidity facility”, which will be managed by the RBA.

“Subject to the availability of the CLF, Aussie banks can’t run out of cash,” CLSA’s banking analyst Brian Johnson says. The CLF will cauterise one of the banking system’s single biggest vulnerabilities: its historically large dependence on wholesale funding. Standard & Poor’s recently cited this as a key risk to Australia’s prized AAA credit rating.

Yet there has been no public debate about the establishment of the facility, the terms under which banks can use it, the risks to which it exposes taxpayers, or the absence of independent oversight of the handful of officials who control it.

BASEL COMMITTEE FINDINGS

The Australian Financial Review has been told that the Swiss-based Basel Committee, which is the supra-national regulator of bank regulators, was initially opposed to what is known as the “Australian solution”. Only one other country, South Africa, has emulated it, although Singa­pore is evaluating it.

Alongside the government’s atypical decision to offer a free guarantee of bank deposits, which the AFR revealed the RBA and Treasury have advised Wayne Swan to reconsider, the facility risks amplifying the “moral hazards” in Australia’s financial system that the International Monetary Fund aggressively criticised late last year.

Reflecting on the ruins left by the global financial crisis, the Basel committee recognised the disaster warranted at least two policy responses.

First, banks should hold more loss-absorbing “tier one” capital to cushion loan losses and, by definition, employ less leverage. It is not widely appreciated but Australia’s four major banks are leveraged 24 to 30 times their capital. This represents the ratio of the dollar value of their assets to their core tier one capital.

The tier one capital ratios quoted in the media are often higher because they assume heavily discounted – or “risk-weighted” – asset values. The Australian Prudential Regulation Authority’sCharles Lattrell says that risk-weighted assets across the major banks are “about 50 per cent” of real asset values. Use of these discounted values understates true leverage.

With actual leverage of roughly 26.5 times, a 4 per cent fall in asset values would, on average, wipe out the major banks’ capital. While the banks are regarded as being durable institutions, it does not take much duress to invoke solvency threats. The Basel Committee’s second finding was that banks should hold more liquidity in the form of high-quality liquid assets to pay out depositors and wholesale bond holders during times of stress.

Almost 60 per cent of Australian banks’ funding comes from deposits. Approximately half of these are at call, the remainder having an average term of six months. The contractual maturity of all deposits is thus less than three months. Almost one-third of other bank funds come from wholesale bonds with an average maturity of about 3.7 years.

MISMATCH AT SOURCE OF FRAGILITY

Much of this short-term money is used to underwrite 25-year home loans. It is this mismatch between a bank’s assets and its liabilities that’s the source of their fragility.

If depositors suddenly demand their money back, banks may not be able to meet their liabilities when they fall due. This is why central banks were created – to prevent bank failures. The RBA has a mandate to act as a “lender of last resort” to banks buffeted by irregular funding shocks. The individual credited with developing the new bailout program was once South Australia’s fastest man over 800 metres. While he loves his hard-core punk rock and is notoriously brusque, he is also one of Australia’s most talented economists.

Guy Debelle will be unlucky not to run the RBA. His fellow MIT PhD, Philip Lowe, is Glenn Stevens’s most likely successor. Before the public launch of its bailout fund, Debelle said the goal of the incoming Basel standards was “to reduce the frequency with which banks might need to seek assistance from the central bank in a liquidity event to a very small number”. “The central bank should be a last resort, not a first resort” he argued. But when the Basel Committee revealed that banks would be expected to hold liquid assets sufficient to withstand a minimum 30-day creditor shock, assessed via a “liquidity coverage ratio”, the RBA’s Martin Place mandarins realised they were in a bind.

Australian banks owe creditors north of $2.7 trillion. If they have to hold liquid assets worth, say, 20 per cent of these liabilities to meet the LCR, they might need as much as $550 billion.

The North American and European authorities championing the liquidity standards have deep government bond markets. But decades of prosperity in Australia, fused with the fact that most credit is intermediated by the four majors rather than via off balance sheet debt issuance, has meant the stock of eligible assets is very small.

‘BRUTE-FORCE’ SOLUTION

If you strip out bonds owned by foreigners, the notional value of debt securities issued by federal and state governments is just $174 billion. Even if the banks owned all these bonds, they would still be short up to $380 billion. This is, therefore, about the maximum expected size of the CLF in current dollar terms. Debelle and colleagues engineered a “brute-force” solution that was novel in its simplicity: in a crisis the RBA would simply lend the banks any shortfall for as long as they needed. This became the committed liquidity facility.

The CLF’s mechanics are not that far removed from the RBA’s existing “market operations”.

There are, however, substantive differences. Monetary policy is set by the RBA’s independent board under its legislation and not by the staff. In contrast, the CLF is completely controlled by the RBA’s executive; the board has no apparent involvement.

Second, the CLF has no clear maximum term but finance provided under the RBA’s market operations is normally restricted to 90 days.

Third, whereas the RBA only accepts a small universe of “bullet-proof” debt securities in its open market operations, which cannot be issued by the counterparty (or related entities), under the CLF banks can use their own loans to back borrowings from the RBA.

Fourth, the RBA executive has given itself absolute discretion to “to broaden the eligibility criteria and conditions for the various asset classes [accepted as collateral] at any time”.

Finally, the CLF was established to ensure Australian banks can always meet creditors’ demands, and has nothing to do with monetary policy.